In the 16th and 17th centuries, the governments of Britain and Spain expended vast amounts of capital to establish ascendancy at sea. Both countries were obsessed with shipbuilding, the primary requirement for asserting power on the water. The construction of the Spanish Armada in the 1580s depleted most of Spain's forests, and the English were forced to import wood in the early 1600s, as naval expansion wiped out their native timber supply, as well.
One can't help but see a familiar pattern in Amazon.com's (NASDAQ: AMZN ) growth strategy, which is almost purely market-share based. This allows it to turn over annual revenue in the tens of billions of dollars with little regard to current profits or retained earnings.
That's not to condemn the company's strategy outright. Despite occasional bankruptcies of the Spanish treasury, and many near-embarrassments of the British coffers, both nations eventually used the seas to their advantage, building huge, if ultimately doomed, colonial empires that returned vast profits to their monarchies.
While Amazon plows ahead in its quest to become the world's preeminent retailer, the market so far this year is apparently taking a different view of world domination: It would like to see a little bit in the way of profits. In circumnavigating the globe, Amazon may face three potential areas of rough waters in the next 12 to 18 months, further testing investors' patience.
Tax provisions are taking a growing bite out of net income
In recent years, Amazon has seen its income tax provision climb sharply. During the last three fiscal years, Amazon recorded total income before income taxes of $1.98 billion, but its income tax provision was $880 million, or more than 44% of total income. In the first quarter of 2014, this trend continued, with the company recording $73 million of income tax expense, an amount equal to 61% of income of $120 million.
A "provision" is different than actual cash paid for taxes. Think of it as an entry on the income statement that a company makes to adjust its current and future tax liability (or tax asset) on its balance sheet. "Income tax expense" is a provision which increases tax liability, whereas an "income tax benefit" reduces tax liability.
In terms of actual checks written to Uncle Sam and other tax entities, Amazon has had a fairly light burden: During the last three years, the company's actual cash paid for taxes stands at a cumulative $314 million, versus the $1.98 billion of income before taxes mentioned above. But it's the provisioning for future liability that presents a real challenge to the company moving forward. As in the current quarter, these provisions can significantly decrease net earnings.
Recent income tax provisioning has been driven by the recording of tax contingencies -- monies Amazon might owe to different tax jurisdictions due to uncertainty over tax positions it has taken. Tax contingencies also include amounts the company projects it could owe to various tax authorities such as the IRS from previously filed tax returns that are under examination. In the last three years, Amazon's recorded contingency has been growing at a very fast clip of nearly 33% per year, from $229 million at the end of 2011 to just less than half a billion dollars at the end of the first quarter of 2014.
Over the years, Amazon has so studiously attempted to be tax efficient -- from forgoing state tax collections for much of its U.S. sales to setting up foreign headquarters in tax-friendly jurisdictions like Luxembourg -- that it's starting to become a victim of the law of unintended consequences. That is, it has to record contingencies on its books for the various, and sometimes aggressive, tax positions it's taken... to avoid paying what it deems unnecessary taxes. As investors reacted adversely to the company's loss guidance of between $55 million and $455 million in the second quarter of 2014, it's predictable that the components of loss will be scrutinized more closely in future quarters. Thus, the tax impacts of Amazon's earnings may be a quickly visible issue in 2014 and into next year.
Superior cash flow may hit hurdles in 2014 and 2015
Above nearly every financial metric, Amazon likes to focus on the amount of operational cash flow it generates. Earnings press releases lead off with the amount of cash flow, not earnings, that the company has produced in a given quarter. In earnings conference calls with analysts, operational cash flow and free cash flow are the first items discussed. Even in its SEC filings, Amazon presents its statement of cash flows before all other financial statements, which is a bit of a rarity, as most companies lead with their balance sheet or statement of operations.
The point not to be missed is that the company wants investors to understand that, despite often meager GAAP net income, when you adjust for non-cash items, earnings look better, and the company believes its cash flow is quite healthy.
As a case in point, in the trailing 12 months ended March 31st, 2014, Amazon earned only $299 million on $78.1 billion of revenue, but it generated $5.3 billion in operating cash flow during the period.
Amazon's ample cash flow has enabled it to enter a number of diverse businesses, from its traditional online retail sales, to Amazon Web Services, or AWS, to content creation, to home grocery delivery via Amazon Fresh. It's also allowed the company to invest heavily in ever-growing office space, a ramp-up in employees last year, and the buildout of 108 global fulfillment centers.
In the last few years, the company's contractual commitments, which are spread among short-term debt repayments and obligations under capital and operating leases, have spiked. For the first time in recent memory, Amazon will be bumping up against significant cash obligations to fund these commitments, most falling due in 2014 and 2015.
The coming cash commitment is easier to understand through the lens of total square footage that the company owns and leases, including its offices, data centers, and global fulfillment facilities. This is a major driver of Amazon's obligations. At the end of 2011, the company owned or leased 48 million square feet in these three categories. Only 24 months later, the company had more than 93 million square feet either owned or under lease:
What magnitude of checks will the company be stroking to cover all this space and other commitments in the near future? Per Amazon's recent SEC annual and quarterly filings, between now and the end of next year, the company has $7.1 billion of various debt, lease, and purchase obligations coming due: $3 billion for the remainder of this year, and $4.1 billion next year. These totals also include equipment leases and purchase commitments for licensed digital-video content.
The company has $505 million of its cash pledged or otherwise restricted for debt covenants, guarantees, and the like. It also has about half a billion dollars in tax contingencies, as we discussed above. The contingencies are highly unlikely to all come due within the next two years; at the same time, management would surely like to have as much reserved in the bank, just in case. So out of Amazon's $5.1 billion of current cash and cash equivalents, we can assume that roughly $1 billion isn't available to fund the upcoming commitments.
Nonetheless, with cash on hand, plus what it will generate during the next two years, the company will cover these obligations. The issue is that Amazon isn't likely to have the huge excesses of cash lying around as it enjoyed previously, and it may have to moderate its spending habits somewhat.
Reduced capital expenditure may slow growth capacity
If spending habits moderate, revenue growth is at risk. Amazon's growth is predicated on its continued cash flow generation, which funds the development of fulfillment centers. The company transfers margin savings from these centers to customers in the form of competitive pricing. To unlock additional sales at its current growth rate (between 15% and 26% per the company), Amazon will have to continue to offer the faster delivery and competitive prices that its fulfillment centers enable in each major domestic and international market.
Yet, with potentially less cash at hand, management may be forced to reduce capital expenditure, slowing the means to build out fulfillment centers and, thus, open capacity for revenue. A similar phenomenon is true of Amazon Web Services, where ongoing investments in servers, software, R&D, and data centers has enabled the efficiency behind the company's 42 customer price decreases since 2008 -- a huge customer attraction.
Theoretically, less vigorous cash flow shouldn't present a huge obstacle: The company can simply refinance some current debt and issue new debt to keep growing. But investors, newly skeptical of Amazon's prospects for earnings, may not appreciate further leverage, and the associated costs of borrowing.
Why Amazon will take ultimate risk
For those who don't understand the compulsion to thoroughly dominate a market, Amazon's reluctance to slow down, prune off a few services, normalize pricing, and enjoy life on decent margins for a few years can be mystifying. Such a path is anathema to Jeff Bezos and his data-driven, ambitious management team. Look for Amazon.com to sail right into these rough waters, and continue firmly on its course of expansion without near-term profits. For those who have missed AMZN's phenomenal stock rise, you may have some entry points in the next two years, as the company's seafaring, adventurous spirit clashes with the suddenly sharpened profit expectations of current investors.
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